Analyzing the SEC’s new Marketing Rule (Rule 206(4)-1, or the “New Rule”) is a monumental task, so I am breaking it down into a series of six blog posts. This first post focuses on the new definition of advertisements and the seven principles-based prohibitions. Later blog posts will cover testimonials and endorsements, third-party ratings, performance advertising, portability of performance and the rule’s administrative requirements.
The SEC adopted amended Rule 206(4)-1, replacing Rule 206(4)-1, the Advertising Rule (the “Current Rule”) and Rule 206(4)-3, the Cash Solicitation Rule. Although all advisers are still held to rigid anti-fraud standards under Section 206 of the Advisers Act, the New Rule provides more specific guidance on the definition of advertisement and replaces the current hodge-podge of no-action letters and other guidance. The New Rule became effective May 4, 2021, and advisers have until November 4, 2022 to comply with the rule.
For compliance officers, the Current Rule has been challenging to explain and difficult to manage. Over the years, as investment advisers increased the sophistication and reach of their marketing materials, the SEC struggled to keep up. Consequently, the Staff tacked on a hodge-podge of no-action letters and guidance to the Current Rule to deal with ever-evolving advertisements.
For better or worse, the New Rule changes the definition of advertisement by focusing on content and covering any means of delivery, not just written and broadcast media. It extends to private fund marketing activity, allows the use of testimonials, codifies prior no-action letters and imposes limitations on hypothetical performance (including target, model and back-tested performance).
On the plus side, the New Rule clarifies that some communications are NOT considered advertising, meaning that compliance professionals won’t have to wrack their brains to draft appropriate disclosures. The SEC called out these examples:
- Unscripted discussions with the press;
- Banners and branding materials (e.g., ABC Advisors sponsors this golf tournament);
- Regulatory filings and required communications;
- General educational materials and market commentary (provided that they don’t contain an offer to provide advisory services); and
- Responses to unsolicited requests from current or potential clients, or private fund investors, including a request for hypothetical performance information.
The New Rule also allows:
- Testimonials or endorsements made for little or no compensation (under $1,000 per year). The change allows firms to include client names as references in marketing presentations (with client permission and disclosure that the client did not receive compensation), without having a written solicitation agreement and accompanying disclosure, as currently required under the Cash Solicitation Rule.
- Discussions of past specific recommendations, such as case studies, in marketing materials as long as the information presented is fair and balanced and appropriate disclosures are included.
Recommendations for Updating Marketing Policies and Procedures
Under the New Rule, investment advisers should consider the following changes to their current marketing policies and procedures including:
1. Updating the definition of “advertising” to include:
a. Any direct or indirect communication an investment adviser makes that (i) offers the firm’s advisory services to prospective clients or private fund investors (e.g., pitchbooks), (ii) offers new advisory services to current clients or private fund investors.
b. Any testimonial (from a client) or endorsement (non-client) where the firm provides cash or non-cash compensation directly or indirectly (such as directed brokerage, awards or other prizes, and reduced advisory fees).
2. Excluding the following from the definition of “advertising” (if applicable):
a. Communications containing hypothetical performance information provided in response to an unsolicited current or prospective client or private fund investor, or to a potential private fund investor in a one-on-one communication. Hypothetical performance includes any type of model performance, back-tested performance, targeted or projected performance, or any other performance that has not been achieved.
b. Live, face-to-face, extemporaneous oral communications. This does not include scripted speeches or replays of previously recorded communications. In the final release, the SEC said this exclusion applies to interviews with the press that are not based on prepared remarks.
c. Information contained in a statutory or regulatory notice, filings or other required communications, provided that the information is reasonably designed to satisfy the regulatory requirements. This excludes the Form ADV Part 2A and Form CRS from the definition of advertisement – assuming the adviser does not include information offering its advisory services with respect to securities.
d. One-on-one, customized communications, such as performance information for a client’s account.
e. Marketing pieces that only refer to the name of the firm. For example, if a piece only displays the name and logo of the firm as the sponsor of an event, this is not considered advertising under the New Rule.
f. General education and market commentary. Educational information is defined as general information about investing, including information about asset classes, strategies, geographic regions, and does not include offers of an investment adviser’s services. Market commentary is also not considered advertising. However, if the market commentary includes a description of how the “adviser’s securities-related services can help prospect investors invest in the market,” this part of the piece would be considered advertising.
g. Private fund communications to investors discussing existing investments in the fund, including:
- One-on-one communications to existing investors
- Information included in a private placement memorandum (“PPM”) about the material terms, objectives, and risks of a fund offering. Content that promotes the investment advisory services of the adviser is considered an advertisement, even if included in a PPM.
- Private fund account statements, transaction reports, and other similar materials delivered to existing private fund investors, and
- Presentations to existing clients concerning the performance of funds they have invested in (for example, at annual meetings of limited partners).
In addition to these definitional changes, advisers will also need to address new prohibitions imposed by the New Rule in their policies and procedures. The SEC replaced the four specific prohibitions (no client testimonials, no past specific profitable recommendations without extensive disclosure, no offer of graph, chart, formula or other device for security selection without disclosure of its limitations, and no offer of free reports, analysis or other services unless it really is free) in the Current Rule with seven general prohibitions. Investment advisers may not disseminate any advertisement that:
- Includes untrue statements and omissions;
- Includes unsubstantiated material statements of fact;
- Includes untrue or misleading implications or inferences;
- Fails to provide fair and balanced treatment of material risks or material limitations;
- Fails to present specific investment advice in a fair and balanced manner;
- Cherry-picks performance results or otherwise presents performance in a manner that is not fair and balanced; or
- Is materially misleading.
These principles are not new. They embody SEC guidance provided through no-action letters, administrative actions, and deficiency letters. The principles place a higher burden of proof on advisers, requiring them to maintain evidence to back up their claims.
Recommendations for Addressing the Seven Prohibitions
- Impartial review. Compliance review of marketing materials is more important than ever. Compliance personnel are paid to protect the firm and therefore have a different perspective from marketing or sales staff or investment personnel, who are compensated for increasing assets. Additionally, compliance officers generally have knowledge of disclosures made in the Form ADV, on the firm website and in private placement memoranda. They have a more holistic view and should be well-positioned to help spot inconsistencies and potential puffery.
- Keep an evidence locker. By using the words untrue, unsubstantiated and misleading, the SEC is sending the message that advisers need to provide evidence to support their claims. Firms should decide who is responsible for maintaining the back up and then test to ensure that the information is being maintained.
- Update your checklists. In the New Rule, under “General Prohibitions,” the SEC repeats “fair and balanced” three times, so advisers should pay attention. When discussing the latest and greatest investment strategy, include information on risks and limitations. For inspiration, check out disclosures on Form ADV Part 2A from other firms engaging in similar strategies. Mutual fund prospectuses can also provide excellent descriptions of risks and limitations.
- Use available expertise. Compliance officers may not always understand more complex analysis being presented in pitchbooks. Consider asking other investment professionals in the firm to review marketing presentations to get their take. An internet search for similar terms can also provide helpful information, although make sure the source is reputable.
- Trust no one. Compliance officers need to employ a healthy skepticism when reviewing marketing materials. Make sure that sources are identified and that the information presented accurately reflects the data. Confirm the integrity of the process for calculating performance. Just think of the case of the outsourced CCO who relied on an email from the adviser’s Chief Investment Officer, providing him with an estimate of assets under management for the firm’s Form ADV. The CIO overstated the firm’s assets under management by 190%. The outsourced CCO was fined $30,000 and banned from the industry for one year!
- Beware of adjectives. Words like best, superior, unequalled, largest, biggest, greatest, and most respected are hard to prove. Avoid phrases like “the firm’s highly successful strategy”, or “attractive risk-adjusted returns.” Examiners are going to want to see back-up data for these claims. Instead, be specific. For example, if you are going to discuss the risk-adjusted returns, include a point of comparison, such as a relevant benchmark.
- Don’t throw out those no-action letters and other guidance. Although the SEC said it would provide a list of no-action letters and other guidance to be withdrawn, nothing has been posted on its website yet. In the meantime, this prior guidance is a good place to start when drafting disclosures. For advisers that advertise their performance, the principles included in Clover Capital Management, Inc. SEC No-Action letter remain excellent guidance. Firms that use hypothetical backtested performance should continue to use In re Schield Management Company et al, In re Market Timing Systems, Inc. et al., and In re Patricia Owen-Michel, SEC Release No. IA-1584. When using partial client lists, check out Cambiar Investors, Inc. When referring to ratings, comply with the DALBAR No-Action letter and the Investment Adviser Association No-Action Letter. Similarly, use the TCW Group, Inc. No-Action Letter and Franklin Management, Inc. No-Action Letter when drafting disclosures for advertisements that discuss past specific recommendations.
Compliance with the New Rule is going to take some heavy lifting. Keep in mind, however, a client’s relationship with their investment adviser is incredibly important, and trust is essential. Clients trusting their hard-earned assets to an adviser should demand nothing less than open and honest communications. The New Rule is aimed at holding advisers to a higher standard of truthfulness.
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